'Inflation' the most disturbing economic phenomenon of recent times

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“Inflation” the most disturbing economic phenomenon of recent times

It is said that in India, people don’t cast their vote but vote their caste. It manifests the importance of caste in Indian political arena, as almost every political party tries to en cash the political mileage by manipulating the caste equations.

Apart from caste, another factor which hugely affects the political agenda of the parties in India is the inflation. Whenever inflation rises above the certain level, political parties start revising their strategy.

Meaning of Inflation

Inflation refers to a persistent rise in the general price level over a period of time. Inflation is not a mere rise in prices but rise must be persistent as well. Few economists like believe that the rise must be persistent as well as substantial. This meant that the short term cyclical fluctuations do not constitute inflation but that rise must be persistent one. Another point that must be remembered is that the persistent rise in the prices of one or two commodities doesn’t constitute inflation but the persistent rise must be in the general price level of the economy.

The general price level refers to the aggregate price of all commodities and these commodities are assigned weight as per their weight in the consumption basket of the consumer. For e.g. in India, the general price level is measured by the Wholesale Price Index (WPI) where different commodities are assigned weight according to their importance in the consumption basket. The rate of inflation is measured by the percentage rise in the general price level over a period of time which is usually a year. In India, inflation rate is measured by the WPI and it is monitored on monthly basis. Suppose if WPI at the end of October 2010 was 500 and at the end of October 2011 was 550, then the rate of inflation in the month of October will be (550-500) / 500 x 100 = 10 %.

Types of Inflation

On the basis of its origin, inflation is divided into following two categories :

1. Demand Pull Inflation

When the price rises due to the spurt in demand, then it is called as demand pull inflation. In such type of inflation, demand in general rises without the corresponding rise in the supply of goods and services, resulting in the overall price rise. The rise in demand is either due to the rise in population or due to the rise in income or both. Increase in population means increasing demand for the food grains, thus a rise in the food prices. Increase in the income of the consumers results in the higher consumption demand, thus the rise in the prices of the consumption goods. This factor as a root cause of inflation in India was recently quoted by PM Dr. Manmohan Singh as an explanation.

Demand pull inflation is also seen when there is a rise in the money supply. Without a corresponding rise in the supply of goods, if there is a rise in money supply, there will be a rise in the price of goods. Suppose in an imaginary economy, if only potato is produced and total amount of potato produced is 100 kg. If the money supply in the economy is Rs. 1,00,000 (which is evenly distributed among its citizens), then the price of potato will be Rs. 1000 /kg. In order to reduce the price of potato, the central bank of that imaginary economy will reduce the money supply to Rs. 10000. With reduction in the money supply, the price of potato will fall to Rs. 100/kg. In India, we often see RBI squeezing the money supply by increasing the rate of interest. Because of such relationship between the money supply and the demand pull inflation, the demand pull inflation is often described as “Too much of money chasing small number of goods.

2. Cost Push Inflation

When the price rises due to the increase in the cost of production, it is called as cost push inflation. The cost of production may rise due to the rise in the price of electricity rates, rise in wages, rise in the price of raw materials, escalation of transport costs due to rise in the diesel prices are few examples of the cost push inflation. In gist, the rise in the input costs gives rise to the cost push inflation. Tackling of cost push inflation requires the structural reforms like power reforms, infrastructure reforms, labor reforms etc.

Inflation also be categorized according to its magnitude

1. Creeping Inflation

When the price rises at very slow pace, it is called as creeping inflation. Usually, a sustained rise in the prices of less than 3 % is termed as creeping inflation. Such inflation is considered safe and essential for economic growth.

2. Walking Inflation

When the rate of rise in the price is in the range of 3 to 10 %, it is called as walking or trotting inflation. Such rate of inflation is a warning signal for the government to control it before it goes out of control

3. Running Inflation

When the price raises rapidly at rate of speed of 10 to 20 percent per annum, it is called as running inflation. Such inflation affects the poor and middle class adversely. It requires strong monetary and fiscal measures.

4. Hyperinflation

When the price rises at 20 to 100 % or more, it is called as hyperinflation or runaway inflation or galloping inflation. It is a situation when the rate of inflation has become uncontrollable and price rises many times a day. Such a situation results in the collapse of the monetary system as the purchasing power of the money falls continuously. Such type of inflation was witnessed by Zimbabwe in 2010 and by Germany in the aftermath of Second World War.

Causes of Inflation

The major causes of inflation are enumerated below –

1. Increase in the money supply- As already illustrated, higher the growth rate of money supply, higher will be the rate of inflation.

2. Increase in Income- When the disposable income in the hands of the people increases, it increases the demand for goods and services thus increasing the consumption, ultimately resulting in the inflation.

3. Increase in the public expenditure- Ever increasing public expenditure increases the aggregate demand for the goods and services. For e.g., the public expenditure in the form of MNREGA increases the disposable income in the hands of the people.

4. Black Money- Black Money is the unaccounted income accumulated by corrupt practices and through tax evasion. Such money creates unnecessary demand for the commodities. Since this money is unaccounted, the monetary and the fiscal policies have little impact on it.

5. Repayment of Public debt- When government repays its domestic public debt, it increases the money supply with the public which tends to raise the aggregate demand for the goods and services.

6. Shortage of the Factors of production- When there is a shortage of the factors of production, viz; land, labours, capital, raw material, and intermediate goods etc, price of such products raises leading to the inflationary pressures.

7. International factors- Today, the world is more interconnected than any time in the history. The price rise in a country having trade relations with most countries results in the export of inflation to the partner countries.

Effects of Inflation

The most direct effect of inflation is the reduction in the purchasing power of the currency. The purchasing power refers to the amount of goods and services, money can buy for its holders. If with Rs. 100 note, one can purchase 5 liters of milk. Inflation increases the price of milk from Rs. 20 / litre to Rs. 25/litre, and now the holder of Rs100 note can purchase only 4 liters of milk. In this manner the purchasing power of money is reduced due to inflation. We can also say that inflation leads to the reduction in the value of money. The most adversely affected section is the salaried class with fixed income because the people with fixed income will purchase less goods and services due to the fall in the purchasing power of rupee.

The fall in the value of money is also reflected in the foreign exchange rate. If initially, 1$=Rs. 50, the fall in the purchasing power of the rupee will depreciate the rupee to say 1 $ = Rs. 52. This depreciation will make the exports costlier, further increasing the price of the necessities which India had to import. For e.g. the crude oil prices in the world are relaxed these days but still it is costlier for the refineries of India due to the depreciation of Rupee. Currently India is witnessing the similar situation where the high inflation rate and the depreciating rupee are complementing each other.

It is because of inflation we have to differentiate between the nominal rate of economic growth and the real rate of growth. Suppose a country is growing nominally at the rate of 14% per annum but the rate of inflation prevailing in that country is 12%. In such a situation, the real rate of growth [Real rate of growth= nominal rate of growth – rate of inflation] of the economy will be merely 2 % per annum because the nominal growth was inflated one due to the price rise.

In the same fashion, we can also differentiate between the nominal and real rate of interest where,

Real rate of interest - nominal rate of interest – rate of inflation.

If Mr. X had deposited Rs. 1000 for one year at 10 percent interest rate in a fixed deposit, then after one year, he will get Rs 1100, thus he gained Rs.100 in form of interest. But if the rate of inflation is 15% during that year, the purchasing power of Rs. 1100 will be Rs. 945 only. Nominally Mr. X gained Rs. 100 due to interest but in reality, he lost Rs. 55 on account of inflation. It the help of this example, it can be explained that due to inflation, creditors lost while the debtors gained due to the inflation. In our example, Mr. X had lost due to inflation but his bank had gained as bank had to pay less money if inflation is accounted because the real rate of interest turns out to be -5 %. Thus the inflation also tends to eat up the savings, eventually hampering the future investment, hindering the rise in production.

Further inflation also gives rise to the uncertainty and thereby increasing the speculation activities where people tend to make quick profits by hoarding or other such practices instead of engaging in the production activities.

Stagflation

Every cloud has a silver lining and silver lining with the inflation is that it tends to increase the employment rate as made evident by the Phillips Curve (the Phillips Curve depicts an inverse relationship between the Price rise and the rate of unemployment). But since mid 1970s, the word witnessed a new phenomenon defying the positive relationship between the inflation and employment. This new situation saw the high inflation along with the high rate of inflation. This situation was called as Stagflation, deriving its name from stagnation and inflation.

Measures to Control Inflation

In order to contain inflation within the safe limits, strong monetary and fiscal measures are required. Under the monetary measures, the central bank squeezes the money supply by increasing the interest rate in order to increase the real rate of interest. The options available with the central bank are repo and reverse repo, bank rate, Cash reserve Ratio etc. The rise in the rate of interest instigates the public to park funds with the bank thus reducing the cash in hand for consumption expenditure; on the other hand it reduces the credit creation from the investors’ point of view.

Among the fiscal measures, government tends to increase the direct taxes which reduce the cash in hand. Apart from this, reduced public expenditure, surplus budgeting, liberal imports, price controls are fiscal measures that are used to contain the inflation.

In India, the origin of inflation can be traced to the both, then demand pull as well as cost push factors. Because of the cumbersome nature of inflation in India, the containment of inflation is also a cumbersome process which needed a vast array of policy measures.

Containment of inflation in India requires structural reforms as well along with the strong monetary and fiscal policy measures. Since the bottom quartile of the population is worst affected due to the inflation, adequate safeguards are necessary for such people and therefore, the containment of inflation is extremely important for the policymakers to achieve the goal of inclusive growth.